Draghi Cuts ECB Rates to Combat ‘Prolonged’ Inflation Weakness

European Central Bank President Mario Draghi speaks during a news conference at the bank's headquarters in Frankfurt on Nov. 7, 2013. Photographer: Ralph Orlowski/Bloomberg

Nov. 7 (Bloomberg) -- The European Central Bank
unexpectedly cut its benchmark interest rate to a record low in
a bid to prevent slowing inflation from taking hold in a still-fragile euro-area economy.

With inflation at the weakest level in four years and less
than half the ECB’s target, the Frankfurt-based bank halved its
key refinancing rate to 0.25 percent in a shift anticipated by
just three of 70 economists in a Bloomberg News survey.

“Our monetary-policy stance will remain accommodative for
as long as necessary,” ECB President Mario Draghi told
reporters in Frankfurt. “We may experience a prolonged period
of low inflation.”

The ECB’s first rate reduction since May burnishes Draghi’s
reputation as a crisis-fighter and aligns his bank with
counterparts such as the Federal Reserve in recently seeking to
reinforce rather than retract monetary support. It leaves the
euro-area’s main rate just a quarter-point from zero, increasing
the likelihood of unconventional tools such as a negative
deposit rate if prices slow further or the economy stalls.

“There comes a point where inflation is so weak, and
coming in weaker than anticipated, that the case for loosening
policy becomes too hard to resist,” said Richard Barwell,
senior European economist at Royal Bank of Scotland Group Plc in
London, who predicted the cut.

Almost exactly two years since he marked his arrival at the
helm of the ECB by paring interest rates, Draghi’s ECB again
sprang into action as the 17-nation economy shows new signs of
fragility after emerging from its longest-ever recession in the
second quarter.

Deflation Fears

Euro-area inflation surprisingly deteriorated in October to
0.7 percent, below the ECB’s goal of “close to but below” 2
percent, sparking fears of a deflationary cycle. Unemployment of
12.2 percent is the highest level since the currency bloc was
formed in 1999, while the euro’s almost 4 percent rise against
its major peers this year is challenging exporters. The ECB will
better detail its economic outlook when it releases forecasts
next month.

The bank kept its deposit rate, which it pays commercial
lenders who park excess cash with it, at zero and cut the
marginal lending rate, that at which banks can borrow money
overnight at any time, to 0.75 percent. That allowed Draghi to
say the ECB still had conventional policies to deploy if needed.

Asymmetric Corridor

Policy makers opted for an asymmetric corridor between the
ECB’s three interest rates to ensure banks continue to be
diligent in planning their refinancing behavior, Draghi said.
Reducing the spread between the main and marginal rates would
increase the risk that banks move away from regular operations
into a facility designed as an emergency fall-back option to
cover unexpected financing needs.

The bank also will extend its unlimited offerings of one-month and three-month cash until the middle of 2015, Draghi
said. The bank chose not to announce a new long-term refinancing
operation in which banks previously borrowed cheaply for up to
three years.

“We continue to monitor closely money-market conditions
and their potential impact on our monetary policy stance,”
Draghi said. “We are ready to consider all available
instruments.”

The euro fell the most in almost two years versus the
dollar, touching $1.3296, the lowest since Sept. 16. Euro-area
government bonds rose, led by Italian and Spanish securities,
with Germany’s two-year rate dropping to the least since July.
The currency was at $1.3386 at 5:49 p.m. Frankfurt time

Money Market

Given that money-market rates as well as financing costs
for companies and households are so low, the rate cut may do
little for the economy beyond helping to restrain the euro and
proving the ECB’s loyalty to delivering price stability, said
Holger Schmieding, chief economist at Berenberg Bank in London.

“The ECB sends a message that it takes the still rather
hypothetical deflation risk seriously,” he said. “The ECB does
not want an even stronger euro to put additional downside
pressures on prices.”

Aside from rate cuts, greater guidance and further
liquidity measures, more expansive steps may be harder to
countenance. A Fed-style quantitative easing program has
repeatedly been ruled out by ECB officials as they are barred by
European Union treaties from financing state debt, making large-scale purchases of government bonds open to a legal challenge.

Negative Rates

While Draghi again floated the prospect of a negative
deposit rate, policy makers have said that its effects can’t be
adequately predicted. A deposit rate less than zero could hurt
banks’ profitability by lowering money-market rates, potentially
hampering credit supply to companies and households and reducing
banks’ incentive to lend to other financial institutions.

Today’s decision comes just three months after some within
the ECB said a rate cut was no longer in the debate following
signs the economy was strengthening. Other central banks are
also reverting to protecting economies from slowdowns in growth
and inflation by keeping monetary policy loose.

The Fed decided in September not to taper its asset-purchase program, while the Bank of Canada dropped language last
month about the need for future rate increases. Emerging markets
from Israel to Chile have cut borrowing costs since the start of
September.

Incredibly Imaginative

The unexpected nature of the rate cut underscores Draghi’s
reputation as a central banker prepared to tackle the challenges
facing the euro head on.

Since he took the ECB’s presidency in November 2011, Draghi
has cut rates by a cumulative 1.25 percentage points, pumped
unlimited quantities of three-year loans into the financial
system and pledged to do “whatever it takes” to defend the
euro. That announcement, in the teeth of criticism from some
central bankers in Europe, helped draw a line under the region’s
debt turmoil.

“I have a huge amount of respect for the Draghi regime,”
said Kit Juckes, global strategist at Societe Generale SA in
London. “He is incredibly imaginative and innovative, even if
he isn’t armed with big-enough weapons.”